Great companies invest in innovation, with those allocating resources to research and development (R&D) tending to generate larger profits than those that do not. However, the world of R&D involves uncertain outcomes and payoffs that can be difficult to measure. Factoring R&D expenditures into profitability and share valuation is far from simple.
R&D Spending and Profitability
R&D spending on its own does not guarantee profitability or strong stock performance. Some companies see a payoff from investing heavily in R&D when projects succeed, while others experience poor performance even after spending significant amounts on R&D. Investors must assess the productivity of R&D dollars. This is where return on research capital (RORC) comes in, a metric that measures the proportion of profits generated from R&D spending in a previous period.
Benefits of High RORC
Identifying companies with high RORC can be worthwhile, as it indicates whether a firm is profiting from new R&D spending or coasting on older innovations. Additionally, it gives investors a sense of whether recent R&D investments are contributing to financial performance.
Calculating RORC
RORC shows how much gross profit is generated for every dollar of R&D spent in the previous year. To calculate RORC, divide the current year’s gross profit by the previous year’s R&D expense. Gross profit can be derived from the income statement, or calculated by subtracting the cost of goods sold from revenues. R&D figures can also be found on the income statement, or capitalized on the balance sheet due to discrepancies between GAAP and IFRS accounting standards.
RORC in Action
To demonstrate how RORC works as an assessment tool, let’s examine Apple (Nasdaq:AAPL) and Nokia Corporation (NYSE:NOK). Using their respective 2009 financial statements, we can calculate RORC based on fiscal 2009 gross profit returns from fiscal 2008 R&D expenditures. Apple’s 2009 gross margin was $13.14 billion, and it spent $1.109 billion on R&D in 2008. This results in an RORC of $11.84 in gross profit per R&D dollar.
Nokia, on the other hand, had a gross profit of €13.264 billion ($17.508 billion) and spent €5.968 billion ($7.877 billion) on R&D in 2008. This gives Nokia an RORC of €2.22 ($4.44) in gross profit per R&D dollar. Clearly, Apple’s RORC significantly outperformed Nokia’s during the same period.
Market Response to High RORC
Examining the 2009 share values of Apple and Nokia suggests that the market rewards companies with superior RORC. Apple’s share price rose significantly, while Nokia’s dropped. The growth Apple experienced during this time was largely driven by solid innovations and a high RORC.
Conclusion
R&D productivity drives technology company profits and ultimately affects share prices. RORC offers investors a valuable method for tracking technology companies’ R&D productivity and provides insight into the direction of their share values.
